ECB Faces Moment of Truth on Bond-Buying Plan

Published September 04, 2012

| Reuters

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European Central Bank President Mario Draghi will try to back up his pledge to do "whatever it takes" to save the euro on Thursday, presenting some details of a new bond-buying plan that is transfixing markets hopeful it can ease the euro zone crisis.

Investors are on tenterhooks after brinkmanship in the ECB's internal negotiations over the plan was played out in public last week, with one newspaper reporting that Bundesbank chief Jens Weidmann even considered quitting.

The ECB is being forced to take a greater role in fighting the debt crisis while governments negotiate legal and political hurdles to coordinating a longer-term response, but Germany's Bundesbank wants to limit the scope of ECB action.

"Draghi certainly has to present something," said Guillaume Menuet, economist at Citi. "A document of some sort, something of substance is what markets want to see in order to justify valuations."

Spanish and Italian government bond yields fell on Tuesday as investors welcomed leaked comments made by Draghi behind closed doors in the European Parliament on Monday, when he suggested the ECB could buy bonds with a maturity of up to three years - at the long end of market expectations.

The ECB is unlikely to reveal all details of the plan on Thursday.

"I'm not sure the ECB is ready to publish the nitty-gritty and the procedures of interventions, because no country has asked (for bailout) and because there are still some important dates in the month that require prior approval," said Menuet.

Spanish Prime Minister Mariano Rajoy said on Sunday Madrid would consider seeking extra aid from Europe on top of an up to 100 billion euro rescue of its financial sector but sees no need for extra conditions beyond the EU policy guidelines it is already implementing.

Rajoy added he wanted to see details of the ECB's program before deciding whether to proceed with a request. EU paymaster Germany and Draghi have said any bond-buying support would require strict policy conditions and enforcement.

German Chancellor Angela Merkel and Rajoy will try to thrash out those differences at talks in Madrid on Thursday, just as the ECB is due to unveil more on its plans.

Spain and Italy have been sucked deeper into the crisis as investors increasingly doubt their capacity to repay their debt. Yields on their bonds have risen to near-unsustainable levels.

Draghi responded in late July by saying the ECB would do "whatever it takes" to preserve the euro, and last month he signaled it was ready to resume buying government bonds.

Now markets want to hear details of the policy. But internal ECB tensions, fuelled by Bundesbank resistance to bond-buying, and the ECB's eagerness to retain an element of surprise mean it will reveal only a partial outline on Thursday.

"We're expecting limited information, no quantitative indication on the targets or quantities to be purchased," Nomura economist Nick Matthews said. "In terms of modalities, we'll probably get something, but very little color in total."

BUNDESBANK OPPOSITION

The Bundesbank vehemently opposes government bond purchases, saying they come close to breaching the taboo of central bank financing of governments, and its criticism has not let up. Its previous head, Axel Weber, resigned in opposition to a previous bout of bond-buying by the ECB.

Disagreements within the policy-setting Governing Council may keep the ECB from giving too many specifics.

The ECB also wants to keep markets guessing about its bond-buying moves to discourage speculators and maintain pressure on governments to pursue economic reforms and fiscal discipline.

Even in the absence of inflationary pressures, the ECB must show its primary focus is still on guarding price stability.

"The ECB cannot announce an additional target of any sort (in addition to the inflation target) because two targets could come into conflict with one another at some future date," UniCredit economist Erik Nielsen said in a note to investors.

Sources have told Reuters the ECB has considered setting interest rate bands - rather than a specific cap - as internal guideline for intervention, but it would not publicly declare any target for yields or spreads that would force it to enter the market when the barrier was exceeded.

Draghi said after the ECB's August 2 meeting that the bond buying would focus on the short end of the yield curve.

His suggestion on Monday that this could mean maturities of up to three years was positive for markets as the longer the maturities the ECB targets, the more bonds it could buy.

"If we are in the short-term part of the market where bonds have a length of time maturity of up to one year, two years, or even three years, these bonds will easily expire," Draghi told a European Parliament committee.

BALANCING ACT

Draghi skipped a weekend policymakers' conference at Jackson Hole in the United States to work on the plan. The ECB has been working around the clock to hammer out the details, but that it has proven tricky.

Weidmann's reported threat to resign, though not confirmed, has piled pressure on Draghi to mollify opponents of the plan without tying it up in so many knots it is rendered ineffective.

One way to placate the Bundesbank could be to insist that the International Monetary Fund - seen as tougher than European Union institutions - is involved in setting conditions for future bailouts, and hence for bond buying, as suggested by ECB policymaker Joerg Asmussen.

"The ECB cannot write a blank cheque," said Menuet at Citi.

"The conditionality precludes an open-door policy. For some investors the ECB involvement is a necessary condition to justify valuations, but it is not sufficient. They will probably need to see a less constrained framework, which they will probably not get," he added.

While the bond-buying plan will be the main focus of Thursday's meeting, there is a chance the ECB will also cut interest rates from 0.75 percent - already a record low - due to a deepening slowdown in the euro zone economy.

Analysts in a Reuters poll are split on the chance of a cut, with a slight majority thinking it will hold fire.

Whether a rate cut comes may depend on how many details of the bond program the ECB can present.

"Draghi will probably disappoint at least marginally on the intervention part, so to compensate for the lack of details on the bond-buying part, they could also be inclined to cut rates," said Nordea analyst Anders Svendsen.